Best Practices

The Practice and Potential Pitfalls of Using Non-Competes to Reduce Tax Exposures Associated with Golden Parachutes

by Edward Hamilton

Golden Parachute awards are a popular strategy for aligning the interests of senior executives and shareholders when a company is being acquired. Large Golden Parachute awards, however, can incur significant tax penalties.

In an acquisition scenario, so-called “Golden Parachute” awards have proven to be a powerful tool for aligning the interests of senior executives and shareholders at the target company. However, the tax code can be punitive when the Golden Parachute award is significant. One element that may help reduce the tax penalty is that if a non-compete is present, its value may be viewed as compensation for agreeing not to compete and offset a portion of the Golden Parachute award. When the parties undertake such a strategy, it is imperative to accurately assess and document the value of the non-compete in the event tax authorities subsequently raise questions.

What is a Golden Parachute?
A Golden Parachute is a payment(s) given to a company executive upon that company’s acquisition. It may take the form of cash bonuses, stock, or other benefits and is awarded to align the executive’s financial incentives with those of shareholders. It is meant to dissuade the executive from opposing an acquisition due to loss of personal benefits – specifically, their job. In the 1980s, there was increasing concern among shareholders and the public in general about excessive Golden Parachutes, which led the government to implement reforms meant to penalize excessive payments. Internal Revenue Code Sections 280G and 4999 concern golden parachutes.

280G and the Double Whammy
A Golden Parachute greater than or equal to three times an executive’s “base amount”, which is the average taxable income in the five years before the transaction, is subject to two significant penalties. First, all amounts greater than the base amount are subject to a 20% excise tax. Additionally, this amount is not deductible by the company for income tax purposes. For example, consider an executive whose average annual compensation is $1 million. The excise tax would apply if the golden parachute is greater than or equal to $3 million. However, the 20% excise tax would apply to the entire payment that is over $1 million.

There are several mitigation strategies, such as reducing the payment to be under the threshold and grossing up the payment to offset the excise tax (and this gross-up would also be subject to the excise tax). Additionally, if there is a non-compete, it is possible that some portion of the amount is payment not to compete, rather than the golden parachute, which reduces the applicable amount. The maximum offset is the lesser of the value of the non-compete or an amount that would be considered reasonable compensation. In the above example, assume the payment was $3.5 million, but the value of the non-compete is $1 million. In that case, the effective golden parachute payment would be $2.5 million, which is under the 3x base amount threshold.

The Criticality of Valuing a Non-Compete
Given the impact of the value of the non-compete on both the executive and the company, understanding the valuation is critical.

A non-compete is valued by considering the economic damages prevented by the non-compete in a hypothetical exercise that considers the impact of the individual were there no non-compete. The first factor is the likelihood of competition, and the second is the impact.

How Likely Are They to Compete?
The likelihood analysis considers factors such as age, health, wherewithal, temperament, skillset, education, and experience. The first gate, reflecting the first four factors, considers the individual’s likelihood of continuing employment. Is the individual young, motivated, and passionate about continuing to work? Alternatively, is the individual experienced, with the wherewithal to retire, and a stated interest in doing so?

Assuming the individual clears the first gate and might continue working, the second gate is the question of how intrinsically tied into the competition they are. Does the person have a functional role, for example, corporate counsel, and a track record of moving from industry to industry? That individual may continue working in a different, non-competitive industry such that the non-compete provides little to no protection to the company. Alternatively, the individual may have an educational background or experience set that means they are intrinsically tied to the competition if they continue working. We have interacted with many executives who have spent their entire careers in one industry and have specialized skills, relationships, and knowledge that make it virtually impossible to participate in another industry at the same level. In this case, if the individual is likely to continue working, it is also highly likely they would continue in the industry – the non-compete is potentially much more critical in protecting the company and, thus, potentially of greater value.

How Would Their Competition Impact the Company?
The second major consideration is the impact on the company. How would the person negatively impact the company? Could they take employees or customers? Is it a salesperson with an established book of business or an individual whose role is more internally facing and who has no interaction with customers? Is it a senior executive with overarching responsibility that could negatively impact the business by going to a competitor and implementing a successful competitive strategy?

Discounted Cash Flow Models, a Reasonableness Test, and the Question of Time
These considerations create two sets of discounted cash flows – the business as it exists and the business as it would hypothetically exist with the individual in competition. The delta between these two values is the value of the non-compete.

Ultimately, both the likelihood and impact analyses have an intrinsic level of subjectivity. However, they must also pass a reasonableness test. If it’s suggested that a person who has a stated desire to retire is highly likely to keep working or someone with zero customer-facing responsibilities is likely to take half of the company’s customers, clearly the reasonableness criteria is not met.

Another key consideration is the period over which to measure the impact of competition. The most conservative approach is only to include cash flows protected during the non-compete period. Alternatively, there is also an argument that actions taken during the non-compete period have an impact afterward. Taking this approach to an extreme—say, by claiming an impact into perpetuity—does not seem reasonable. However, when there is a clear linkage between actions taken during the non-compete period and the impact afterward, capturing this benefit in the calculation may be appropriate. An example might be a customer that typically has a five-year contract. While only some customers would be available for the taking during a one-year non-compete, any that are taken would also be lost for the duration of the contractual period.

As the analysis is often an income-based approach, one key question is the appropriate discount rate. In line with best practice when valuing intangible assets for financial reporting purposes, calculating an internal rate of return (IRR) that equates the forecast/deal model and the purchase price helps the analyst select and calibrate an appropriate discount rate for the non-compete.
Finally, there may be questions about enforceability. If the individual is in a state where non-competes are unenforceable or banned, by definition, there is no value in a non-compete. There are several states, California being the most prominent example, where non-competes are banned. Other states have limits such as breadth or an income threshold. Additionally, in early 2023, the FTC proposed banning all non-competes, which, if implemented, would negate the value associated with a non-compete.

Beyond their primary function of protecting acquiring companies against competition by former executives of a target company, non-competes may represent an effective tax-mitigation tool by reducing the nominal size of Golden Parachutes. However, valuing non-competes requires a great deal of science and a bit of art as well.

Edward Hamilton, CFA is a managing director with Valuation Research Corporation who specializes in the valuation of businesses, intellectual property, assets, and liabilities for financial and tax reporting purposes.